Wealth creation has historically been one of the most sought after goals of mankind and when it comes to new age wealth creation tools –> INVESTMENTS has been the most popular and sought after medium to do so. Theoretically investment principals are very simple, you just need to BUY low and SELL high! But in real life things are not so simple and since there are lots of variables like emotions , lack of discipline, timing the market, lack of information etc a lot of retail investors end up on the losing side and fall into the reverse trap of buying high and selling low. In today’s article we cover an important and effective tool called REBALANCING which retail investors can use not only to minimize the risk but also to maximize the market fluctuation opportunities thus boosting their wealth creation process.
What is Rebalancing: Rebalancing in simple terms is ensuring the asset allocation ratios remain intact over a period of time. Portfolio management starts with arriving at an optimum asset allocation ratio basis one’s financial goals and risk appetite. Step 1 of asset allocation is to arrive at a percentage split of asset category (equities, mutual funds, fixed income tools like bonds & FDs, cryptocurrency, alternatives like gold, land, metals etc and cash). It is always advisable to have a mix of categories which move in opposite directions so as to provide a level of hedging. Investors with high risk appetite might choose greater allocation for equities & crypto and vice-versa for people with lower risk appetite. Also as we near our retirement age it is advisable to gradually change the allocation from high risk to low risk. Step 2 of asset allocation is then to arrive at an appropriate mix within each category. For eg within crypto/equity we now decide the ratio split within large, mid and small cap. Further for both step 1 and 2 investors can choose among even, linear & exponential strategies. Step 3 is then choosing the right company/project/government to allocate your funds (Objective is to find good projects at cheap price. Identify projects with high ROCE (return on capital employed), low debt, high PBIT, good use-case, good team/management etc).
Now that our asset allocation is done and capital deployed as per the ratios it’s important to understand that these ratios undergo moderations with passage of time due to market fluctuations. Everything which goes up, at some point comes down and vice versa. If we do not manage our portfolios during these changes over a period of time the portfolio deviates from its original allocation and thus either gives us lower returns or becomes more risky. This is where REBALANCING comes into picture to ensure our initial portfolio allocations remain intact over a period of time thus maximizing gains and minimizing the risks. This means we sell a part of our portfolio which goes up and allocate those gains to the portfolio which has come down in value to bring portfolio allocation ratios back to initial levels. For eg in a particular period equities and cryptocurrency do well while bonds give lower returns , the result will be that our risk reward ratio will change and portfolio overall risk weighted average will increase. At this stage we need to book the profits gained in the increasing market and allocate those funds to buy more of bonds till our allocation ratios comes back to original levels. Similarly within the category we need to identify the coins/stocks which gained, hence have a high standard deviation risk score(i.e a higher probability of price dipping) sell them to buy coins/stock which have low percentage portfolio weightage compared to initial level and buy them as they now have higher probability of gaining price.
Why Rebalancing: Various researches on rebalancing suggest that it delivers better results than HODL (Hold On to your Dear Life) strategy. This reduces the volatility of the market by ensuring the averages are in the favor of the investor. High standard deviation portfolio is replaced by low standard deviation portfolio thus reducing the risk hence capital protection plus increases the probability of higher gains as the current low standard deviation portfolio is expected to deliver relative better returns in the future. Rebalancing also makes the process uncomplicated as it is based on simple and sound mathematical principles thus helps an investor save a lot of time and energy. Additional to this it also helps in tax benefits as most of the portfolio is prevented from LTCG (Long Term Capital Gains). Portfolios not rebalanced tend to become more risky over time. In nut-shell rebalancing helps an investor in ‘buying low and selling high’.
How to Rebalance: Rebalancing is typically done using 2 strategies -> 1. Time based 2. Deviation or Threshold. In time based strategy rebalancing is done at pre defined time intervals (1 hour, 1 day, 1 week, 1 month). At the end of each time interval the portfolio is rebalanced to achieve the pre-defined asset allocation. Back tests on previous market data suggest that lower is the rebalancing duration higher is the returns in comparison to HODL strategy. Threshold strategy basically does the portfolio rebalancing only when the deviation crosses a pre defined level. For eg if you have allocated 20% for BTC and the market grows, typically in such situation alts grow faster and the percentage contribution of BTC to the portfolio dips. If we keep the threshold at 5% then the moment BTC contribution dips to 15% the rebalancing is triggered and alts are sold to buy more BTC to bring BTC contribution back to 20% and vice versa in case the market dips. For retail investor time based strategy works well as it is simple to understand and execute.
Future of Rebalancing: Rebalancing as an investment strategy is recommended by many investment gurus and finance experts and thus is here to stay. However till recent times because of the technicalities involved its use was limited mostly to financial experts, fund managers etc. However automation and artificial intelligence advancements are making it much more convenient for retail investors to use it. Algorithms are now available to do the rebalancing on behalf of customers without their manual intervention. This allows customers to continue focusing to work on their core activities without having to worry about tracking the markets frequently and without having to go through the emotional rollercoaster ride of market ups and downs. Automation takes emotions out of the investment behavior thus an automated rebalanced portfolio doesn’t miss out on booking the profits of a market gain nor does it miss out on buying the dip. Automation thus reduces the chances of missing out of an opportunity. As the level of awareness about automated rebalancing spreads a huge upsurge of retail customers are expected to jump on this band wagon. This eventually will also help the overall market stabilize much more as these automated tools will ensure whenever markets dips more buying happens bringing the market up and whenever market pumps the selling happens to rebalance the portfolio thus averaging out the market price. A stable & predictable market is always safer for retail investors as it offers high level of capital protection and organic growth of funds.